It’s all down to the market

Published in The Weekend Australian (Sydney), 2 May 2009

In an email debate, David Hetherington and Oliver Hartwich discuss the coming budget, whether the Government’s stimulus package is wise and sustainable, and what Treasurer Wayne Swan should drink on budget night.

DEAR David,
Budget day is coming up and it’s times like these when I realise that I am still unfamiliar with Australian traditions. I have no idea how you celebrate budget day.

In Britain, where I spent the past four years, the chancellor of the exchequer traditionally has a glass of whisky before the budget debate and carries his papers in this famous old red briefcase. In Germany, where I grew up, budget debates are usually rather boring because all the important figures are known way in advance.

But in Australia? From what I gather, treasurers like to excite everyone with a few headline-grabbing measures, new spending plans, a tax cut here and there. Given our economic circumstances, I wonder whether this really makes much sense, though. Aren’t times exciting enough (if not to say nerve-racking)?

As the world economy is tumbling the potential effects of national fiscal policy are limited, especially in a small economy. It’s hardly possible to compensate for the decline in overseas markets. And, in any case, the real problem in the global economy is the breakdown of the banking system. This can’t be solved by fiscal activism.

No, I don’t think it’s the right time for exciting budget plans, let alone for yet another round of fiscal stimulus. The previous two packages did not prevent us sliding into recession, either.

So I hope the Treasurer refrains from such measures. Maybe he should just calm his nerves with a glass of whisky?

Oliver

PS: By the way, a good scotch should also stop him from putting up the excise on whisky.

Hi Oliver,

I’m not sure whether the Treasurer enjoys a quiet pre-budget beverage but he certainly deserves one. As Laurie Oakes wrote last week, an Australian treasurer hasn’t faced such a challenging budget since the Depression.

Tax receipts are falling, welfare claims are climbing, the global recession has hit home and there are political commitments to meet, such as the pension hike.

I suspect exciting is the last thing Wayne Swan is looking for right now.

I agree that the big problem in the global economy has been the banking system collapse. But it just doesn’t follow that our Government can’t respond to the downturn.

The responsibility of the Australian Government is to protect jobs and the economy. The Government and its financial regulators have a range of tools to respond to the crisis – interest rate cuts, stimulus spending, labour market programs, emergency credit lines – and they’ve rightly deployed all of them.

It seems you’re saying that stimulus spending is a waste of time because the crisis is just too big. But stimulus spending sustains jobs and boosts consumer confidence, exactly what the economy needs. And what isn’t spent is saved, reducing our enormous household debt.

Thousands of additional jobs would have been lost had the Government not acted when it did. We’d be facing a far deeper recession today. Each of these jobs represents a breadwinner with a mortgage or rent to pay and a household to feed.

This is where economics meets reality. For the Government to sit on its hands because the problem is too big is simply negligent. It’s enough to drive anyone to whisky.

David

Dear David,

Let me just check with you whether I understand you correctly: you say that the Government’s stimulus package has worked because people spent the money or they used it to repay their debt.

Well, if this is how you define success, then the Government simply cannot fail, by definition. When you send people a $900 cash bonus, of course they can spend or save it. But neither one nor the other really makes this good policy.

In the former case, private consumption is temporarily lifted but public debt remains. In the latter, public debt simply replaces household debt. In both cases what you leave the country with is a much higher public debt burden. Whether this makes a positive contribution to economic growth is doubtful, to say the least.

We only need to look at Japan to see that such policies do not work. For more than a decade the Japanese have tried stimulus package after stimulus package. Unfortunately, the country did not return to economic growth. The only thing that grew was gross public debt, which stands at well more than 100 per cent of Japanese gross domestic product. It is the hangover from their stimulus binge.

The first rule in medicine is to do no harm. I prefer governments refraining from harmful interventions over governments pursuing dubious policies just because they want to be seen doing something.

Only quacks pretend there’s a painless cure for every disease.

Oliver

Hi Oliver,

I’m saying that the recession will be far less severe with the stimulus than without. Stimulus spending cushions the economy and reduces job losses. No serious economist questions this.

Good fiscal policy builds surpluses during the growth phase of the business cycle and supports the economy by spending during a downturn, using deficits if necessary.

Yet you suggest that stimulus spending is harmful. I’m guessing you mean that although it provides a short-term boost, the spending relies on debt, which eventually must be repaid.

But this ignores the flip side of the cycle. When growth begins, tax receipts pick up and welfare demands fall away, allowing the Government to pay down debt and restore surplus.

If you doubt this, ask Treasury just how fast tax payments flowed in during the recent boom, smashing forecasts year after year.

You’re right that Japan’s stimulus packages could not rescue its economy, but this was because they were too conservative in cleaning up their banking system, not because fiscal policy is fundamentally flawed. Happily, Australia’s banks are far stronger, placing us in good stead for recovery once global growth returns.

Given you feel that government intervention isn’t the way to go, can I ask if you think we should just leave markets to fix themselves? It strikes me that the embrace of unfettered, self-correcting markets has been a root cause of this crisis. What do you reckon?

David

Dear David,

You are right: I think that stimulus spending can provide only some short-lived relief while leaving a long-term legacy of debt.

Of course, in the textbook of Keynesian economics such things would never occur. As soon as the economy picks up again, enlightened politicians are supposed to repay the debt they incurred in the downturn. In reality, however, this hardly happens. Just look at Europe, where they are still paying interest for their 1970s stimulus packages.

It’s true that after Australia’s previous recession the debt was repaid. But this happened only because of two highly unusual and unique circumstances: the sale of state-run companies and a resources boom. We cannot expect similarly benign conditions after this recession.

We seem to agree that this crisis has its roots outside Australia and that it began in the financial sector.

But if that is the case, then the potential of domestic stimulus packages is limited.

By the way, this is not to say that we should not have a budget deficit now. Let the automatic stabilisers work. However, I would not go beyond this.

You will not be surprised to hear that I don’t share your view that “unfettered markets caused the crisis”. Which unfettered markets did you have in mind anyway? The state-run US mortgage lenders Fannie Mae and Freddie Mac? The state-owned central banks? The phenomenon of government-mandated lending to poor Americans?

I am the last person to deny some market failure in this crisis. But it was preceded by government failure and it is now made worse by yet more government failure.

Yes, there is such a thing as a self-correcting market. I am not sure whether we’ll see a self-correcting government, though.

Oliver

Hi Oliver,

Weren’t Australian governments in the 1980s and ’90s self-correcting? They turned a closed, stagnating economy into a dynamic, globally engaged success story. Trade liberalisation, financial deregulation, the currency float, product and labour market reform set the conditions for our subsequent prosperity.

Where governments have failed in this crisis has been their inability to curb market failure through better market design.

One example of a missing design feature in banking was counter-cyclical reserves: holding more capital in good times when you can afford it and less in bad times when you’re struggling to stay afloat.

You ask which unfettered markets I have in mind. The ones that offered mortgages for more than the value of the home. That didn’t hold enough reserve capital to sustain their lending. That traded derivative products without any idea of their underlying value. And that paid executives unthinkable sums for failing their shareholders and employees.

As hard as I look, I don’t see these markets self-correcting any time soon; markets have inherent imbalances that often tend to failure. So it’s going to be government redesign, not the markets themselves, that fixes these failures.

You claim that governments are making the failures worse and we should just wait for markets to sort it all out. But there are two problems with simply letting the market take care of our biggest problems. Markets do not price in social costs and benefits, so they rack up costs (such as carbon) while ignoring benefits (employment). And markets assume that participants are perfectly informed, rational decision-makers when as individuals we know we are anything but.

This is not to say market forces can’t play a positive role in our society; they can. But they must be harnessed by good market design in the pursuit of social as well as economic value.

David

Dear David,

I have always waited for this day, but it has finally arrived: when the director of a left-of-centre think tank argues the case for trade liberalisation, financial deregulation, floating currencies, product and labour market reform, you know that the debate about economic rationalism is over.

I wonder whether I shall send you a membership application for the Centre for Independent Studies?

Joking aside, I think it is encouraging that there is much agreement in principle that free markets (usually) work.

The CIS has been saying this since it was founded in 1976. In the early days of the CIS, such views were met with contempt and ridicule. Today even our fiercest opponents would not argue against the crucial reforms of the ’80s and ’90s.

As you correctly say, the reforms based on these ideas turned Australia into the prosperous country it is.

You are right: markets aren’t perfect. But, then again, what is? Do you think people become more rational, more enlightened, more responsible if you take them out of a bank or a corporate boardroom and put them in charge of a ministry, a central bank or government agency? As the great economists of Depeche Mode sang in the ’80s, “people are people”.

As long as we’re all human, there will always be errors, follies and failures. Nevertheless, it’s easier to deal with them when they happen in the marketplace.

By the way, of course I agree with your claim that there should be good market design. But who would call for bad market design?

Now that we have basically agreed on the principles of good economic policy, the only question that remains is the choice of drink for the Treasurer when he presents the budget.

Any ideas? Na zdorovye.

Oliver

Hi Oliver,

I’m afraid the debate on economic rationalism is far from over.

As I’ve explained, I think market forces are powerful mechanisms that can be harnessed by governments for the public good.

But this is a long way from an embrace of free markets. Free-market champions espouse flat taxes, small government and minimal regulation while ignoring social costs and benefits.

I’d prefer progressive taxes, smart government (sometimes bigger, sometimes smaller), good market design and a valuation of those costs and benefits.

The problem with free markets is that no market is truly free. They suffer from externalities, poor information, bad incentives and-or concentrations of market power. They’re also populated by people who often behave irrationally, and predictably so.

This is where economics is moving beyond rationalism. We can design market mechanisms that harness predictable irrationality for better outcomes in areas as diverse as chronic gambling, personal savings and obesity.

Studies tell us that, in repeated interactions, people prefer to collaborate rather than compete. We can estimate the returns on investing in human capital.

Perhaps its biggest flaw is the belief that it is values-neutral. Wealth creation is its only goal. Because they don’t account for fairness as well as prosperity, for community as well as the individual, free markets alone will never offer a sufficient basis on which to build a decent society.

As for the Treasurer, let’s hope he reflects on all this with his well-deserved drink. Like any proud Queenslander, he’ll probably settle for a XXXX Gold.

One thing you can be sure of is that it won’t be an alcopop.

David

David Hetherington is executive director at Per Capita. Oliver Hartwich is a research fellow at the Centre for Independent Studies.